UPDATE 3-Bank of Canada holds rates but talks of more hikes, boosting C$

OTTAWA, Jan 9 (Reuters) - The Bank of Canada held interest rates steady as expected on Wednesday but said more increases would be necessary even though low oil prices and a weak housing market will harm the economy in the short term.

Governor Stephen Poloz said the challenges were temporary and he still believed the economy would at some stage be “operating at full capacity ... with inflation on target and with interest rates in a zone where they are no longer stimulating or contracting aggregate demand”.

The bank has raised rates five times since July 2017 and as recently as last month said the pace of tightening could be sped up depending on economic data. But on Wednesday it said rates would need to rise “over time,” the first time it has used those words to describe the pace of tightening.

Poloz told a news conference the reference to “over time” was “meant to inject a degree of ambiguity into the timing” of future rate increases, given the setbacks from oil and housing.

The talk of further hikes helped boost the Canadian dollar , which extended earlier gains, touching C$1.3180 to the U.S. greenback, or 75.87 U.S. cents. It later settled back to C$1.3225 to the U.S. dollar, or 75.61 U.S. cents.

“It’s a bit more hawkish than the market expected ... At this point, the market was expecting that maybe we are done,” said Benjamin Tal, deputy chief economist at CIBC World Markets.

The central bank cut its near-term growth forecasts to reflect the impact of crude prices but said the slowdown should be temporary and predicted the economy would post above-potential growth in 2020.

The bank noted that much of the economy was operating close to capacity but said consumption spending and housing investment had been weaker than expected as housing markets adjusted to tougher mortgage rules and higher interest rates.

Looking ahead, the bank said exports and non-energy investment were expected to grow solidly, moved forward by foreign demand, a new North American free trade pact, a weaker Canadian dollar and federal tax measures aimed at investment.

The bank noted signs that the U.S.-Chinese trade war was hitting global demand and commodity prices but adopted a positive long-term outlook.

The bank held its overnight interest rate at 1.75 percent, well below the “neutral” rate of 2.5 percent to 3.5 percent, where monetary policy is neither stimulative or accommodative.

“We still expect further modest tightening this year ... They’re indicating that there’s an ongoing commitment to move official rates to a neutral range so further rate hikes are in the offing,” said Paul Ferley, assistant chief economist at the Royal Bank of Canada.

The bank cut its forecast for fourth-quarter annualized growth to 1.3 percent from the 2.3 percent it predicted in October and pegged first-quarter growth at just 0.8 percent. It trimmed the forecast for overall 2019 growth to 1.7 percent, from 2.1 percent.

Investment in the Canadian oil and gas sector would decline by about 12 percent in 2019, compared with the 1.5 percent drop it predicted in October, it said.

The bank said the damage that current low oil prices will inflict on the economy would be about a quarter of that done during a crude slump from 2014 to 2016. Since that time the importance of the energy sector has lessened. (Additional reporting by Matt Scuffham, Nichola Saminather, Fergal Smith and Anna Mehler Paperny in Toronto; Editing by Steve Orlofsky and James Dalgleish)